The Promise and Challenge of Integrated Risk Management

Abstract

INTRODUCTION In the past, risk management was rarely undertaken in a systematic and integrated fashion across the firm. Integrated risk management has only recently become a practical possibility, because of the enormous improvements in computer and other communications technologies, and because of the wide-ranging set of financial instruments and markets that have evolved over the past decade. A sophisticated and globally tested legal and accounting infrastructure is now in place to support the use of such contractual agreements on a large scale and at low cost. Equal in importance to this evolution in capital markets is the cumulative experience and success in applying modern finance theory to the practice of risk management. Today, managers can analyze and control various risks as part of a unified, or integrated, risk management policy Integrated risk management is the identification and assessment of the collective risks that affect firm value, and the implementation of a firm-wide strategy to manage those risks. Integrated risk management, then, looks well beyond the set of traditionally insurable risks, seeking to address all of a firm's risks within an organized and coherent framework. At the foundation of risk management is the integration of the three ways that a firm can alter its risk profile. These fundamental ways that a firm can implement risk management objectives, by modifying the firm's operations, by adjusting its capital structure, and by employing targeted financial instruments, interact to form the firm's risk management strategy. Managers must weigh the advantages and disadvantages of any particular approach in order to find an optimal mix of the three. Traditional insurance, then, a type of targeted financial instrument, is but one tool available to the firm. This article presents a managerial overview of integrated risk management, investigating the range of management decisions that it can influence and the benefits for the firm from its implementation. To illustrate these concepts, the article places a special focus on one firm, Honeywell Inc., and its first steps toward integrating traditionally insured risks with other treasury-based risks. WHAT IS RISK MANAGEMENT? Traditionally, risk managers focused on insurable risks and loss control. To those outside the insurance industry, however, risk management tends to evoke thoughts of derivatives and strategies that magnify, not reduce, risk. While today's risk management may use derivatives, derivatives, as a risk management tool, are only a small part of the integrated risk management process. Moreover, a proper risk management strategy does not involve speculation, or betting on the future price of oil, corn, currencies, or interest rates, and indeed is antithetical to such speculation. Instead, the goal of integrated risk management is to maximize value by shaping the firm's risk profile, shedding some risks while retaining others. By applying integrated risk management, managers will benefit from new insights about the interplay among different types of risk and traditional financial decision areas, connections easily missed without a comprehensive framework. Because the three ways to manage risk are functionally equivalent in their effect on risk, their use connects seemingly unrelated managerial decisions. For instance, because capital structure is one component of a firm's risk management strategy, effective capital structure decisions cannot be made in isolation from the firm's other risk management decisions. Consequently, a firm's capital structure choice is inextricably linked to its capital expenditure plans, along with many other operational decisions. This article's discussion of the integrated risk management framework emphasizes the connection among the ternary mechanisms to alter the firm's risk profile and offers guidance on their practical application. BENEFITS OF INTEGRATED RISK MANAGEMENT A cascade of basic decisions about objectives faces the manager who seeks to implement a risk management program. …